Keep your finances on track and gain greater degree of certainty

Financial tracking takes two forms: for investors, it seeks to replicate a given published list, usually of shares, whilst for borrowers, it follows a defined interest rate.

Chosen carefully, tracker finance can provide a greater degree of certainty even though it may not be as exact as a groove cut in a record. In the case of investing, it may well bring cost savings as computer models replace the stock-picking expense of professionals.

Many actively managed funds under-perform their benchmark index and yet savers have to pay additional charges for the service. It is hardly surprising that there has been a major movement to so-called ‘passive’ funds such as trackers where the costs are far lower.

However, “even with trackers, the cheapest is not always best”, warns Samantha Paskin-Bywater, an independent financial adviser at Chase de Vere in Leeds. “Different passive funds use alternative techniques to track their target indices and if their strategy is not effective then a passive fund can potentially under-perform or out-perform significantly.”

The best approach is to hold both active and passive funds. The former should be used in sectors where a fund manager can out-perform – such as smaller companies or emerging markets – whilst trackers are apt for areas where higher stockpicking performance is unlikely, such as large cap UK and US equities.

Take care on the composition of a proposed index as some have a large bias to particular sectors. For example, gas, oil and mining account for 27 per cent of the FTSE top 100 companies with financials – mostly banks – a further 20 per cent. Few would wish to hold such a high proportion in banks and an active manager could reduce or eliminate such holdings but an index investor would be forced to place their money there.

Tracker funds are now becoming more sophisticated. For example, if looking for income, specify one which replicates shares paying high dividends whilst for security look for those based on size or turnover.

Before deciding on a tracker provider, establish if it undertakes full replication of a published index with all the underlying stocks held or partial replication where a sample is purchased.

Costs are typically far lower with a tracker – often around 0.2 per cent for a quality one – by comparison with an active fund, which can charge 0.75-1.5 per cent. Providers will quote the total expense ratio (TER) but transaction costs of trading assets are usually additional.

Any fund shadowing an index will experience some deviation but compare the tracking error with competitor funds.

With 36, HSBC is one of the largest providers of tracker funds. Good examples include the FTSE All-Share Index and American Index. The former costs just 0.28 per cent whilst Virgin Money charges a full one per cent.

Moving slightly away from trackers are exchanged traded funds (ETFs). These are open-ended collective investments that can be bought and sold through a stockbroker.

With a synthetic ETF, the manager makes an agreement with a third party investment bank to swap performance of a collection of investments in exchange for the exact return of that stock market or commodity.

This is a derivative contract and brings extra risks, notably if the third party should fail, some of the investment could be lost. Perhaps not surprisingly, ETFs are not protected by the Financial Services Compensation Scheme.

Martin Payne, Leeds director at stockbrokers Brewin Dolphin, uses ETFs “to cover areas difficult to buy into through other forms, like precious metals”. Such funds can purchase and store the physical commodity, meaning that investors are exposed to the ‘spot price’ of the asset.

Some subjects, like oil, cannot be bought and so depend on the futures price. He advises against using ETFs where the index is heavily influenced by state agencies.

Three of the largest ranges are provided by Legal & General, db x-trackers and iShares. Amundi, a French-based provider, uses a synthetic approach and quotes in euros.

For a balanced portfolio and lower cost providers, consider:

n Large caps, such as the FTSE 100 with Vanguard’s very cheap 0.1 per cent fee.

n Mid-range FTSE 350, like Royal London ETF (0.12 per cent pa plus initial 5 per cent).

n Global, such as HSBC MSCI World ETF (restricted to developed world)(0.35 per cent fee) or Vanguard FTSE All-World ETF (including emerging markets)(0.25 per cent).

n Emerging, such as Vanguard FTSE Emerging Markets ETF (0.45 per cent fee).

n Gold, such as iShares Physical Gold ETC (0.25 per cent).

Chelsea Financial Services, private client advisers, say that ETFs can allow savers to gain access to parts of the market – like single commodities – not available through other means. “Commodity funds tend to be invested in equities linked to commodities rather than the real assets themselves,” says Darius McDermott at Chelsea Financial.

Jonathan Baker, at Charles Stanley stockbrokers in Leeds, prefer not to use trackers as clients expect to outperform the market. He warns that some trackers with the highest charges “often have the worst tracking error”.

He is also concerned that one firm or sector can distort an index, like Vodafone in the late 1990s and banks in 2007.

Barclays Stockbrokers say that FTSE trackers accounted for 40 per cent of its clients trades in April. The popular choices were iShares FTSE 100, ETFS Physical Gold and – for those seeking the American developed equity market – iShares S&P 500.

One of the less well-known fields to track is property. Castle Trust is a housing investment and shared equity mortgage provider, which was launched last October. It offers two investments linked to the Halifax House Price Index: Income HouSA and Growth HouSA, both of which can be taken out for terms of three, five or 10 years.

The minimum investment is £1,000 and there are no annual management charges. The former tracks any rise or fall in the Halifax Index and pays an annual income of two to three per cent depending on the term chosen. Investors receive their capital back plus or minus the percentage change in the Index.

The Castle Trust Growth HouSA offers a gain of 1.25-1.7 times any rise on the Index or a loss of 0.75-0.3 times any decline. An initial fee up to three per cent is payable depending on the terms agreed with the financial advisor (0844 620 0160).

Borrowers who use a tracker for a home loan have the benefit that the interest rate is set by an external benchmark, usually Bank Rate but in a few cases Libor. This prevents the lender from not passing on the rate tracked in full, although with Bank Rate at 0.5 per cent, the scope for further cuts is negligible.

Read the small print carefully so that a repeat of the recent Bank of Ireland scenario does not arise where borrowers found that a clause allowed it to amend the interest rate.

Comparing the spread between Bank rate and lenders’ standard variable rates today with 2007 (when Bank rate peaked at 5.75 per cent), Ray Boulger, of mortgage brokers John Charcol, says it “shows the value of this guarantee. In 2007, the spread was around two per cent. Today, even the most competitive SCRs are almost 3.5 per cent higher and several around 5.5 per cent above”.